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Terms of Trade vs. Balance of Trade: Which Matters More?

Explain the difference between the terms of trade and the balance of trade in goods and consider whether an economy should be more concerned about its terms of trade than its balance of trade in goods.

Category:

International Trade and Exchange Rates

AS Level Cambridge 2023 Paper 22

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Answer

(Step 1 : Introduction, Explain the difference between terms of trade and balance of trade in goods)

In international economics, two critical concepts often discussed are the terms of trade (ToT) and the balance of trade in goods. Understanding the distinction between these two measures and their respective impacts on an economy is essential for policymakers and economists.

✍️Terms of Trade (ToT):

A country’s current account position is heavily influenced by its relative export and import prices. Th e terms of trade is a measure of the ratio of export prices and import prices.

The formula for calculating ToT is:

TERMS OF TRADE = (Index of export prices/Index of import prices) x 100

If the index increases, this is described as a favourable movement or an improvement in the terms of trade.
It means that fewer exports have to be sold to buy any given quantity of imports.

An unfavourable movement or deterioration in the terms of trade means that the index number has fallen. Now more exports will have to be exchanged to gain the same quantity of imports.

✍️ Balance of Trade in Goods:

The balance of trade covers the exports and imports of goods such as cars, TVs and clothing.
Exports give rise to credit items while imports give rise to debit items. The trade in goods balance is the revenue earned from exports of goods minus the expenditure on the imports of goods.

The balance of trade in goods is a straightforward measure, calculated as the difference between the value of a country's exports of goods and its imports of goods:

Balance of Trade=Value of Exports−Value of Imports

A trade in goods surplus arises when export revenue is greater than import expenditure.

(Step 2: consider whether an economy should be more concerned about its terms of trade than its balance of trade in goods)

✍️Effects of Changes in Terms of Trade:



1. Competitiveness:

A deterioration in the ToT, where import prices rise relative to export prices, can reduce a country's global competitiveness. This change can make domestically produced goods more expensive and less attractive on the international market.

2. Inflation:

Fluctuations in ToT can lead to inflationary pressures. A rise in import prices relative to export prices, for instance, can result in cost-push inflation, increasing the cost of imported goods and services.

3. Impact on current account:

An unfavourable movement in the terms of trade may actually reduce a deficit on the current account of the balance of payments. If the Marshall-Lerner condition is met, the fall in export prices relative to import prices should increase export revenue relative to import expenditure.


Note: While a rise in the terms of trade is described as a favourable movement, its impact is not always
favourable. Th is is because its eff ects will depend on its cause. If the price of exports increases because of a rise in demand then it is likely to be benefi cial as more domestic products will be sold. If, however, the cause is a rise in the costs of production, demand for the country’s products will fall and export revenue may decline.


✍️Effects of Changes in the Balance of Trade:

1. Economic Growth and Employment: A surplus in the balance of trade can be a boon for economic growth and employment. Higher export revenues can lead to increased production and job creation within the country.

2. Inflation: Conversely, a trade surplus might lead to an appreciation of the domestic currency, which can have deflationary effects by making imports cheaper and exports more expensive.

✍️What an economy should be more concerned about:

The relative importance of ToT and the balance of trade in goods varies based on a country's economic context. For nations heavily reliant on exports, ToT is a crucial indicator as it directly impacts their purchasing power and overall economic health. A favorable ToT can mean greater efficiency in how a country utilizes its export revenues to purchase imports.

On the other hand, countries focusing on bolstering their domestic industries might find the balance of trade in goods more significant. A positive balance of trade can indicate a thriving domestic industry, potentially leading to higher employment rates and economic stability.

(Step 3: Conclusion)

Conclusion:

In conclusion, the choice between prioritizing ToT or the balance of trade in goods depends on the specific economic structure and objectives of a country. Economies with a strong export orientation might place more emphasis on ToT, as it directly affects their global competitiveness and purchasing power. In contrast, economies aiming to strengthen their domestic market might focus more on achieving a favorable balance of trade.

Both indicators are vital for assessing a country's trade health and guiding policy decisions. Understanding and monitoring both measures are essential for a comprehensive analysis of an economy's international trade dynamics.

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